Nowhere To Hide: Ernst & Young Looking At More Civil Liability For Lehman Failure

The Lehman Bankruptcy Examiner’s Report is an aggravating example of, “Be careful what you wish for.” The mainstream media (MSM) is now paying attention to the Big 4 – Deloitte, KPMG, PricewaterhouseCoopers, and Ernst & Young.

The financial crisis is now about accounting fraud.

Every two-bit journalist and blogger on the business beat is spitting out stories to keep up and one-up each other. It’s not every day that the accounting firms provide so much gossip about spectacular criminal and civil penalties. Well, actually, it is every day. There’s almost a thousand stories in the re: The Auditors pointing to just such an outcome if any of the Big 4 ever looked down the barrel of a litigation shotgun like Lehman.

Ryan Chittum is a Staff Writer for The Audit, part of the Columbia Journalism Review where he critiques media coverage of business.

Yes. It really is called The Audit.

On March 15th Ryan claimed blogs are beating MSM on the Lehman story but lamented the short attention spans of most publications.

“Look, I know that Lehman collapsed a year and a half ago, but this is a major story—one that finally gets awfully close to putting the crimes in the crisis. I’ll go ahead and say it: If you’ve wanted to know about the Valukas report and its implications, you’ve been better served by reading Zero Hedge and Naked Capitalism than you have The Wall Street Journal or New York Times…”

Welcome to my world, Ryan.

On March 16th, Ryan over-the-knee spanked John Carney, Managing Editor of Clusterstock, for tripping all over himself arguing against prosecutions for Lehman scandal actors.

“I suppose we shouldn’t be surprised that John Carney thinks “We Should Not Criminally Prosecute Lehman Executives.” After all, this is someone who is a fan of insider trading, which he says “harms no one” and ought to be legalized….”

I agree with Ryan. John Carney has it all wrong. Does being on TV a lot create the delusion that wishing can make it so? John Carney practiced law. He knows better.

Anton Valukas, the Lehman Bankruptcy Examiner and Chairman of law firm Jenner & Block, knows his way around white-collar and corporate defense. If Valukas points to “colorable claims,” I’m apt to believe there’s some colorful legal culpability to see. Jenner & Block had so many lawyers working long hours on the report, Valukas probably had Gene & Georgetti’s on speed dial.

But the Examiner’s Report is still developing. Valukas points to many areas where he had neither the time nor the stomach to explore further. He not so subtly tells other interested parties to go wild.

Is Ernst & Young going to fail like Arthur Andersen?

These are easy tropes to toss – Andersen, Enron and off-balance sheet shenanigans. But the Repo 105 discussion is a distraction. So is the “Sarbanes-Oxley failed us” whine. Repo 105 is not off-balance sheet accounting but good old-fashioned “round-trip” transaction shenanigans. This was garden variety accounting manipulation by the highest levels of the corporation, accomplished with the acquiescence of the impotent auditors. I described these techniques three weeks ago, “…Can Anyone Catch Lehman Stealing?” But finance bloggers often shine these turds to make them worthy of their dazzling quanty brains.

The biggest criminal exposure for the Lehman executives comes from their alleged lies about the use of the Repo 105 transaction as a “sale” or revenue recognition transaction versus a financing technique. This was not disclosed. They skipped it in the filings and confirmed these lies when signing false quarterly Section 302 certifications. These are criminal violations of law. We may also learn these sleights of hand with scienter were designed to provide cover for insider trading or options backdating activities. Those actions would also be criminal. And then there’s the possibility Fuld and others lied to Congress or other investigators. That could handcuff their attempt to avoid criminal prosecution.

Lehman executives are already defending against significant civil suits. I think more suits will be filed naming directors, especially audit committee members, in spite of the pass they got from Valukas. There are already tons naming executives, directors, Ernst and Young and others as defendants.

Ernst & Young is now vulnerable to more suits, better-drafted suits, bigger than $1 billion dollar suits. Civil suits won’t to kill EY right away. EY may die, however, from suffocation if their legal contingency numbers rise rapidly enough. Or they may suffer a slow death from a thousand cuts when the cost to defend the firm becomes overwhelming. But the public won’t know because the Big 4 audit firms do not issue audited financial statements and do not disclose their legal contingencies or their reserves for those contingencies. We’ll have to depend on the regulators to keep an eye and make a plan if the cookie starts to crumble.

Arthur Andersen died because a criminal indictment prohibited them from signing audit opinions. That’s the business they were in and they were forced to turn in the keys. But Andersen was already on life support because of the number of lawsuits they were facing prior to Enron, the overwhelming costs of that defending themselves and the inevitable settlements. The end was already near.

EY is not likely vulnerable to criminal indictment as a firm. There may well be something they should be indicted for. But the US Department of Justice has no appetite for throwing kerosene on this smoldering pile of dung. EY may be subject to criminal indictments outside of the US. The loss of the EY UK member firm would be as crippling to the network as loss of the US firm. The UK regulatory authorities are questioning EY due to the cross-border Repo 105 transactions and their use of UK law firm Linklaters as a “fixer.”

I would bet real money EY will have to testify before the House Oversight and Financial Reform Committee soon. Legislators may finally get heads out of the ratings agencies’ ass and realize that the accounting firms are supposed to serve the public interest. The Big 4 abandoned this public duty a long time ago, Sarbanes-Oxley or no Sarbanes-Oxley. Add lying to Congress to their list of sins if they screw this up.

Finally, the EY audit partners will be delivered to gallows by their firm. Regulators and the Department of Justice have signaled they will nail individuals for civil sanctions and penalties as well as criminal violations. It happened at KPMG. They tossed partners overboard to avoid a prosecution from their tax shelter scandal. EY recently disowned partners who went to jail for similar crimes. But we may see EY sheltering Lehman audit partners Schlich and Hansen until the firm cuts their own deal.

Francine, I have been blogging about this one all week, and I don’t usually do in-depth financial or accounting blogging.

When I worked in Lehman Japan in 2007, it was actually at the invitation of the Fixed Income Division product support because they couldn’t figure out a growing expense issue. It turned out, the unit was borrowing money, in yen, for Lehman affiliates to invest abroad —the completely legitimate “yen carry trade”. And apparently no one higher up thought that as a distinct unit, Lehman Japan was supposed to receive revenue when they lent the money internally. Not just pay the expense to the outside party.

In that time, I remember that Repo 105 came up as a designation. But it was just talked about like any other repo. I had also seen something eeriy silmilar to that four-box chart Valukas has to describe the flow of the transaction, but I’m not sure the party who showed it to me even understood what a repo was. Throughout the project, I was amazed by the lack of talent in the unit. Accounting talent, business talent.

The only kind of hint that something would be amiss, in retrospect, is that the gang must have had a really tight “net capital” position. Valukas says that the non-LBIE (i.e Lehman Europe) affiliates were booking the transactions on a GAAP basis, and that the fraud was committed by manual entries between LBIE and the parent in New York. So the affiliates where the money came from must have had considerably over-extended balance sheets. (This is even before considering whether the different packages of loans, the so-called “toxic securities” were valued appropriately—what the mainstream media has focused on since September 2008.)

If those guys in Tokyo were in on it, it was really quite an act. Because they had legions of people that made me wonder how they even had control jobs.

It must be that the people at the level of Erin Callan on the business/trading side had to know that the significance of “105” was to do a transaction where the liability side would end up NOT recorded on the books. The rest of the firm below could have been unaware, just saying “hey, we’re doing some more 105 this quarter” and wondering how thin Lehman was going to stretch its firm capital. But the counterparties, like whichever banks were on the other side of the 105, probably wondered why Lehman was only taking $1 for every $1.05 it offered in good collateral. When people who do trading are fighting over mere basis points (0.01%), why is a firm going to give away 5% or 4.76% of its potential repo power for nothing? The counterparties were getting a sweet deal, way out of proportion to how the rest of trading in the bond industry went.

So at some level, the Big People had to be saying within Lehman, that they “structure” the transaction that way so that they don’t have to record the loan from the bank. Wouldn’t that even make the newly-minted undergraduate accounting grad wince?.

A tough thing about REPO 105 transactions: You can’t argue they were immaterial because they wouldn’t have done the transaction if that was the case.

Will they be put out of business? Probably not. E&Ywill have to pony up money for a settlement. E&Y just treats this as a cost of doing business. If the case went to court, it would probably take years to get anything. I think the plaintiffs will accept a settlement that won’t put E&Y out of businesss. The only chance that E&Y could get put out of business is if the SEC takes the type of action that was taken with AA. But I am not aware of a consent decree that E&Y has ever signed such as the one AA signed with respect to settle Waste Management in which AA agreed not to commit any more violations. It was the pattern of repeat violations that caused the SEC to go after AA.

It’s possible that someone will pursue the counterparties to the REPO 105 transactions similar to what happenned with respect to some of the investment banks that did business with Enron and hid Enron’s debt. There is a lot of litigation to come.

Ok, I’m just now picking up on this Repo 105 ordeal. So a couple questions (and I apolgoize in advance if my Qs aren’t clear enough): If Lehman essentially treated the Repo deal as a sale, wouldn’t that make their balance sheet look worse because that’s billions of dollars in assets that are completely off their books because of the “sale”. I mean the goal of Lehman was to make their balance sheets look healthier than it actually was, right? Second, when Lehman went bankrupt, what happened to the overcollaterized securities that the counterparty “bought”? Did they profit off the difference b/w the overcollaterized assets they received and the amount they gave to Lehman?

This is just me speculating here but I would think the entire purpose of recording Repo 105 as a sale would be to create the appearance that Lehman had adequate cash on hand to calm fears of a liquidity crisis. If you book Repo 105 as a sale you have $100 of cash in hand versus $105 of illiquid securities that you’re required to repurchase 10 days later. The $5 loss from recording the transaction as a sale was worth the hit if it makes you look liquid and avoids a run on the bank.

[…] My response to John Carney and a scathing indictment of his point of view by Ryan Chittum in The Audit, a Columbia Journalism Review (CJR) blog, earned me a substantial mention in a later post by Ryan at CJR. I also was linked to by Aaron Task in a summary of the controversy on his Tech Ticker site. […]

The actual transaction was meant to reduce liabilities (increase net capital). The only way to do that is to shrink the asset side as well. So the Repo 105 transaction was the giving over of $105 collateral in order to get a $100 loan. Because the repo was structured just that way, Lehman said that it didn’t have to record the loan. That is, forget the CR entry “loan due” when it came to consolidation.

You are right that cash appeared on the books. (DR cash), but it was subsequently used to pay off other liabilities. In Valukas’ first three examples of the Examiner’s Report, he shows the normal case. Then in the last two, the Lehman Repo 105 one.

[…] The biggest case of Section 302 certification fraud is staring the SEC and Justice Department in the face and they’ve done nothing about it for more than two years. The biggest criminal exposure for the Lehman executives comes from their alleged lies about the use of the Repo 105 transaction as a “sale” or revenue recognition transaction versus a financing technique. This was not disclosed. They skipped it in the filings and confirmed these lies when signing false quarterly Section 302 certifications. These are criminal violations of law. We may also learn these sleights of hand with scienter were designed to provide cover for insider trading or options backdating activities. Those actions would also be criminal. And then there’s the possibility Fuld and others lied to Congress or other investigators. That could handcuff their attempt to avoid criminal prosecution. […]

Hello,
I`m Estonian student and I`m writing a survey about Lehman Brothers auditing fraud. I have been looking for information about the auditor (E&Y). I really haven`t found what happened with the auditor and the main figures of Lehman Brothers (punishment).

Maybe someone can help me, because I am really in trouble and i have been spent a lot of time already for looking information. I am very happy if anyone will spent a bit time to help me out

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About the author

Francine McKenna (@retheauditors) is the Transparency Reporter at MarketWatch.com, a Dow Jones publication, where her work is also featured frequently in the Wall Street Journal. McKenna had more than twenty-five years of experience in consulting and professional services including tenure at two Big 4 firms, both in the US and abroad before becoming a journalist. Look for her prior columns, "Accounting Watchdog" at Forbes.com and "Accountable" at American Banker. For more information, click "About" at the bottom of this page. For more information contact Francine McKenna, fmckenna@mckennapartners.com